H2 Economics Definitions

Important Terms & Definitions | H2 Economics

Copyright 2008-2010. Woon Wei Seng. 1

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IMPORTANT TERMS & DEFINITIONS [ECONOMICS]

Microeconomics

1. Introduction to Economics

Scarcity Situation where limited resources available unable to satisfy unlimited

human wants

Opportunity Cost (OC) Cost of any activity measured in terms of next best alternative forgone

Production Possibility Curve

(PPC)

Shows all different maximum attainable combinations of goods &

services produced when all available resources are used efficiently at

given state of technology

Law of Increasing Opportunity

Cost

As more of a good is produced, more of another good has to be

sacrificed in production

Comparative Advantage When one can perform an activity at a lower opportunity cost than

anyone else

Law of Comparative Advantage Trade can benefit countries if they specialize in goods in which they

have a comparative advantage

2. Demand & Supply

Law of Demand Inverse relationship exists between price of good and quantity

demanded of good, ceteris paribus

Law of Supply Direct relationship exists between price of good and quantity supplied

of good, ceteris paribus

Price Elasticity of Demand (PED) Degree of responsiveness of quantity demanded of good to a change in

its own price, ceteris paribus

Income Elasticity of Demand

(YED)

Degree of responsiveness of demand to a change in income of

consumers, ceteris paribus

Cross Elasticity of Demand (XED) Degree of responsiveness of demand for one product to a change in

price of another, ceteris paribus

Price Elasticity of Supply (PES) Degree of responsiveness of quantity supplied of good to a change in its

own price, ceteris paribus

Consumer Surplus (CS) Excess of price buyers willing and able to pay for good over actual price

paid

Producer Surplus (PS) Excess of what producer willing and able to put up for sale for a good

over actual price paid

Deadweight Loss Loss in welfare not gained by anyone in society

Tax Incidence Division of tax between consumers & producers

Subsidies Fixed amount of money given to producers for each unit sold that

lowers cost of good

Price Floor (minimum price) Legally established minimum price above market equilibrium price

Price Ceiling (maximum price) Legally established maximum price below market equilibrium price

Black Market Market where sellers ignore governments price restrictions & sell

illegally at whatever price equates illegal demand & supply

3. Cost Theory & Size of Firms

Fixed Factor Factor of production whose quantity cannot be changed in short run to

change output

Variable Factor Factor of production whose quantity can be changed within time period to

change output




Short Run Production period in which there is / are fixed factor(s)

Long Run Production period in which there are no fixed factors

Law of Diminishing Marginal

Returns (LDMR)

As more units of a variable factor are added to an unchanging fixed factor,

the marginal product generated by adding the variable factor will

eventually decrease

Marginal Cost Additional cost from additional output

Economies of Scale Unit costs decrease as scale of production increases

Diseconomies of Scale Unit costs increase as scale of production increases

Minimum Efficient Scale

(MES)

Occurs at where LRAC curve stops falling / lowest point of LRAC curve

Internal Expansion Expanding productive capacity to enjoy internal EOS

Horizontal Integration Merger of two firms at same stage of production

Vertical Integration Merger of two firms at different stages of production

Conglomerate Integration Combination of two firms of different industries with nothing in common

4. Perfect Competition & Monopoly

Perfect Competition Market of many buyers and sellers of a homogeneous good

Monopoly Market of only one seller of a product without substitutes (absence of

competition)

Price Taker A firm that takes the price from the market as given, without ability to

influence the price

Price Setter A firm that has the ability to influence the market price

Productive Efficiency Occurs when firm is able to produce an output at any point along LRAC curve

in long run or least cost at any given period

Allocative Efficiency Occurs at where output level when price of good equals marginal cost of

producing it

Natural Monopoly When it is cost efficient to have a single firm in the industry such that it has

lower AC (substantial EOS) over range of market demand

Predatory Pricing Selling below cost price to drive out competitors

Cartel Agreement among existing suppliers to keep out competitors

X-inefficiency Occurs when a firm becomes complacent and suffers from inefficiency due to

lack of competition

Price Discrimination Charging different prices for the same product or for different units of it

when such price differences is not because of cost differences

1st

Degree Price

Discrimination

Monopolist sells each unit to consumers at maximum price they are willing to

pay

2nd

Degree Price

Discrimination

Monopolist sets uniform price per unit for specific quantity of good and

lower price per unit for subsequent units

3rd

Degree Price

Discrimination

Monopolist charges different prices for the same commodity in different

markets

5. Oligopoly & Monopolistic Competition

Oligopoly Market where few large firms have large market share

Monopolistic Competition Market where many small firms exist, each providing different products or

services

Price Rigidity Tendency for prevailing market prices to remain stable over a long time

Mutual Interdependence Each firm affects rival firms decisions and are also affected by rival firms

decisions




Product Innovation Differentiation of product in consumers viewpoint through improvements to

product

Process Innovation Reducing AC without sacrificing profits through streamlining processes

Brand Proliferation Firms produce many brands to saturate market, leaving no gaps for rivals

Market Segmentation Segmenting market into sub-markets / market niches with different needs

catered through product innovation

Kinked Demand Curve Theory Explains price rigidity; TR falls when prices rise / fall as rivals will match price

decreases but not price increases

Price Wars Used to eliminate new competitors, when a firm lowers its price, other firms

start lowering prices and keep undercutting competitors price

Collusive Oligopoly When there are tacit / explicit agreements among firms on operations

Cartel Theory Formal arrangement by sellers to fix prices through manipulating supply to

the market

Price Leadership Theory Oligopolists agree to set same price as price leader in industry, allowing price

adjustments without price wars

Dominant Firm Price

Leadership

Others in industry follow largest producer in industry in price changes

Barometric Firm Price

Leadership

Others in industry follow price changes of producer most sensitive to market

conditions

Contestable Market Theory In a market of free entry & exit, number of firms in industry unimportant

since firms always behave as if competition is very strong (no matter number

of firms)

Differentiated Product Product that is slightly different from and yet close substitute to product of

other firms in industry

Product Development Production of good with potentially high demand and different from

products of rival firms or provision / improvement of service to better / differ

from rivals

Excess Capacity Theorem Firms inefficient in using societys & own resources, thus not producing at

socially ideal output

6. Alternative Theories of the Firm

Profit Satisficing Where managers of firm make enough profit to satisfy shareholder demands

instead of profit maximizing

Managerial Theories Managers, with discretionary power and freedom to run the firm, maximize

their own utility instead of profit

Revenue Maximization Firms aim to maximize sales revenue instead of profits

Growth Maximization Firms aim to maximize growth instead of profits

Organizational Slack Tendency of firms in non-competitive markets to produce at higher than AC

(X-Inefficiency)

Nationalization Industry put under ownership and control of the state

Privatization Returning state-owned corporations to private sectors, involving transfer of

assets from public to private sector

7. Market Failure & Government Intervention

Social Efficiency / Pareto

Optimality

Achieved when no one can be made better off without someone being made

worse off

External Benefits Benefits from production / consumption experienced by people other than

the producer / consumer (third parties)

External Costs Costs from production / consumption experienced by people other than the

producer / consumer (third parties)




Private Marginal Benefit

(PMB) of good

Value the consumer places on last unit of good produced, equal to price and

thus represented by demand

Private Marginal Cost (PMC)

of good

OC of resources used up in making additional unit of good, represented by

supply

Social Marginal Benefit

(SMB)

Sum of PMB and External Benefit to represent marginal benefit on society

Social Marginal Cost (SMC) Sum of SMC and External Cost to represent marginal cost on society

Underproduction When in the production of the good, SMB > SMC (production can be

increased to socially optimum output)

Overproduction When in the production of the good, SMC > SMB (production can be

decreased to socially optimum output)

Market Failure Free markets, operating without government intervention, fail to deliver

socially efficient allocation of resources to produce good & services

Public Good Good / service with characteristic of non-excludability and non-rivalry

Positive Externalities Benefits from production or consumption experienced by society but not by

producers or consumers themselves

Negative Externalities Costs from production or consumption experienced by society but not by

producers or consumers themselves

Merit Goods Goods or services deemed socially desirable by government and seen as

underproduced and thus underconsumed

Demerit Goods Goods or services deemed socially undesirable by government and seen as

overproduced and overconsumed

Geographical Immobility Where barriers to people moving from one region to another thus

disallowing resources to respond to incentives to produce more goods &

services demanded

Occupational Immobility Mismatch of skills as labour is not transferable across industries as

demanded, leading to waste of resources

Government Failure Allocative efficiency is reduced following government intervention aimed to

correct market failure




Macroeconomics

1. National Income Accounting

National income Total value of an economys final output of goods & services in a year

(NNP at Factor cost)

Households Basic consumers of finished products & owners of factors of production

Firms Basic producers of finished products & buyers of factor services

Gross Domestic Product (GDP) Total market value of all final goods & services newly produced within

country

Gross National Product (GNP) Total market value of all final goods & services newly produced by

productive factors of countrys citizens (GDP + NPIA)

GDP/GNP per capita GDP / GNP divided by population

Net Property Income from

Abroad (NPIA)

Difference between property income from abroad & factor income paid

abroad

Market price Value of output at shop level / price purchasers pay for goods & services

sold

Factor cost What factors of production received for goods & services produced

GDP at Factor cost (GDP at market price Indirect tax + Subsidies)

Capital depreciation Loss in value of physical assets due to wear & tear

Net National Product (NNP) (GNP Depreciation)

Real GNP Level of output in terms of physical quantities without price changes

(Nominal GNPGNP deflator)

Nominal GNP Value of output measured at current prices

Purchasing Power Parity (PPP) How much goods & services can be bought by a unit of currency at

home compared with purchasing power of other countries currency

2. National Income Determination

Keynesian Theory Fundamental problem causing depression is insufficient demand for

goods & services, so fiscal policy can revive the economy

Desired Aggregate Expenditure

(AE)

Total planned expenditure on goods & services in an economy (C + I + G

+ X M for 4-sector economy)

Equilibrium NI Level of NI once reached will be maintained unless the economy is

disturbed

Leakage / withdrawal Siphoning off of expenditure from income flow between firms &

households

Injection Additional expenditure into domestic income flow

Autonomous consumption Minimal consumption households will still spend when income is zero

Induced consumption Amount of consumption changing when income changes

Average Propensity to Consume

(APC)

Proportion of total income consumed (CY)

Average Propensity to Save

(APS)

Proportion of total income saved (SY)

Marginal Propensity to

Consume (MPC)

Change in consumption as income changes (CY or 1 MPS or 1 -

MPW)

Marginal Propensity to Save

(MPS)

Change in saving as income changes (SY)

Marginal Propensity to

Withdrawal (MPW)

Change in withdrawals as income changes (MPS + MPM + MPT)

Investment Expenditure on production of capital goods and net additions to goods




stocks

Marginal Efficiency of

Investment (MEI)

Negative relationship between interest rates & level of investment

Government expenditure Current spending & capital spending by the government on provision of

goods & services

Full-employment level of NI Level where there is no deficiency in demand / full employment of

production factors / production on PPC

Deflationary gap Shortfall of AE below NI at full-employment level, causing demand-

deficient unemployment

Inflationary gap Excess of AE above NI at full-employment level, causing demand-pull

inflation

Multiplier (k) Number of times income changes as injection changes (IAE)

Aggregate Demand (AD) Inverse relationship between price level & real equilibrium output

where planned spending = actual output

Aggregate Supply (AS) Amount of goods & services all firms in economy willing to supply at

different price levels

3. Unemployment & Inflation

Unemployment Number of people of working age without work, but willing & able to

take up employment

Overheating Economy growing too quickly that high inflation occurs

Labour force All within working age (15




Tax-push inflation Inflation caused by increases in indirect taxes adding to cost of living

Wage-price spiral Prices keep rising in vicious cycle as wages rise to offset higher costs of

living & firms increase prices to cover appreciating costs of production

Anticipated inflation Where rise in general price level is expected

Shoe leather costs Costs incurred by people & firms trying to minimize holdings of cash

4. Public Finance

Current / Ordinary expenditure Expenditure incurred in day-to-day routine work and recurrent year

after year

Development / Capital

expenditure

Spending on public investment

Progressive tax As income increases, proportion of tax on one's income increases

Regressive tax As income increases, proportion of tax on one's income decreases

Proportional tax As income increases, proportion of tax on one's income remains the

same

Income tax Tax on 'earned' & 'unearned' income, taxed progressively

Corporation tax Tax on firm's profits, usually taxed proportionally

Capital gains tax Tax on capital gains and capital appreciation of assets (land, shares etc)

Property tax Tax on annual rental value of land & buildings, usually proportional tax

Stamp duty Tax on legal & commercial down payments

Ad valorem tax Tax on fixed proportion of value of good or service (%)

Specific tax Tax on fixed amount per unit of good or service ($)

Value-added tax (VAT) Multi-stage tax levied on net value added at each stage of production

Excise duty Tax on manufacturer of goods so as to curtail domestic consumption

Customs duties / Tariffs Tax on goods imported from outside the country, to raise revenue or for

protectionist reasons

5. Fiscal Policy

Government budget Estimate of government revenue & expenditure for coming year

Balanced budget Estimated revenue = Estimated expenditure

Deficit budget Estimated revenue < Estimated expenditure

Surplus budget Estimated revenue > Estimated expenditure

Deficit financing Financing extra spending by government through other methods (e.g.

borrowing)

Fiscal policy Government policy where government expenditure is increased & taxes

are reduced to stimulate economy

Automatic fiscal stabilizers Built-in features of economy operating automatically to smooth out

fluctuations in disposable income over business cycles, without

government intervention

Disposable income Income households have available to spend after paying income taxes &

receiving transfer payments (e.g. unemployment benefits)

Crowding-out effect Government cuts taxes or expands borrowing to finance increased

expenditure, crowding out private investment due to higher interest

rates

6. Interest Rate Determination & Monetary Policy

Money supply Quantity / Stock of money held by households & firms in economy




Demand deposits Money deposits in checking accounts (for checks)

Nominal money Amount of money in dollars & cents

Real money Amount of goods & services one can purchase with the money

Money substitutes Items serving as temporary medium of exchange but not stores of value

Fiat money Notes & coins determined as legal tender but not backed by gold,

circulated by faith alone

Interest rates (Rate charged) Cost of borrowing & reward for lending

Nominal interest rate Interest rate charged by lender

Real interest rate Nominal interest rate minus inflation rate

Demand for money Desire to hold money rather than spend it or for financial investment

Liquidity preference Desire to hold non-interest bearing cash balances as part of wealth

portfolio instead of interest-bearing bonds

Transactions motive Cash balances to meet planned expenses

Precautionary motive Cash balances to meet unforeseen expenses

Speculative motive / Idle

balances

Cash balances to purchase assets & bonds to make capital gains

Total demand for money Active balances (Transactions motive & precautionary motive) + Idle

balances

Loanable funds Funds available for lending

Central bank Institution supervising monetary system, implementing monetary policy

& ensuring banks & financial institutions operate efficiently

Monetary policy Deliberate attempt by Central Bank to regulate money supply or

manipulate interest rates

Irrational exuberance Consumers continue to spend regardless of high interest rates because

of high consumer confidence

Velocity of money Rate at which money supply turns over each year

7. Economic Growth

Economic growth Annual percentage increase in real value of goods and services

produced by economy

Actual economic growth Annual percentage increase in national output

Potential economic growth Speed at which economy could grow / Percentage annual increase in

economy's capacity to produce

Human capital Accumulated skill & knowledge of workers

8. Supply-side Policy

Supply-side policy Focusing on adjusting AS such that the AS curve expands outwards

Prices & income policy Direct or indirect intervention by government on wage-price setting to

influence inflation rate

Earnings Wages + Overtime payments + Bonuses

9. International Trade

Trade Exchange of goods & services between two parties

International trade Exchange of goods & services across national borders

Factor price equalization Prices of factor inputs brought closer to each other

Absolute advantage Where a country can produce more of a good using the same amount of

resources




Comparative advantage Where a country can produce a good at a lower opportunity cost than

another country

Law of comparative advantage Trade can benefit all countries if they specialize in goods in which they

have a comparative advantage

Terms of trade (TOT) Rate at which one good can be exchanged for another

Terms of trade index Comparison of export price index with import price index (Export Price

Index/Import Price Index X 100%)

Balance of trade (BOT) Difference between value of commodity exports & imports (Export

revenue-Import spending)

Free trade Exchange of goods & services between countries without any artificial

restrictions

Protectionism Policy of sheltering domestic industries from foreign competition

through tariff & non-tariff barriers

Infant industry Industry with potential comparative advantage but too young /

undeveloped to realize potential

Dumping Selling of goods in foreign market below cost price / price sold in home

market

Import quota Legal limit on quantity of imports over given time period

Subsidy Indirect protection of domestic producers so they become more

competitive against more efficient foreign producers

Voluntary restraint agreement

(VRA)

Agreement to reduce trade volume in specific good

Exchange control Government's buying & selling of foreign exchange to regulate imports

& exports to ensure healthy BOP and prevent undue fluctuations in

country's foreign exchange value

Embargo Total ban on certain imports

Economic integration Neighboring countries integrate as an economic unit to take advantage

of extended market & allow better allocation of resources

Free trade area (FTA) Agreement where member countries agree to remove tariff & non-tariff

barriers among themselves but retain restrictions against non-member

countries

Trade deflection Imports enter FTA via country with lowest external tariff

Customs union (CU) Agreement where member countries remove all trade barriers among

themselves & adopt common external tariff for non-member countries

Common market Member countries operate as a single market, lifting all restrictions on

trade in services, capital & labour movements and adopting laws &

regulations on trade, production & employment

Trade diversion Trade diverted from more efficient non-member producer to less-

efficient but tariff-free member nation

Balance of payments (BOP) Summary statement of money value of economic transactions between

country residents & rest of world

Credit item (+) International transaction earning foreign currency, providing demand of

domestic currency

Debit item (-) International transaction requiring foreign currency to make payments,

providing supply of domestic currency

Current account Flow of goods & services + incomes & net transfer of money flowing into

& out of country

Trade in goods account Import & export of tangible goods

Trade in services account Import & export of services (invisibles)

Income flows Investment income in forms of rent, interest, profits & dividends (net

property income from abroad)




Current transfers Unilateral flows such as government contributions & receipts from

international organizations & remittances

Capital account Records debt forgiveness, migrant transfers & acquisition & disposal of

non-financial assets such as patents & copyrights

Financial account Records purchase & sales of assets in terms of direct investment,

portfolio investment & monetary flows

Direct investment Purchase & sale of real assets (capital goods)

Portfolio investment Purchase & sale of shares & bonds (long-term investment)

Monetary flows Bank deposits, loans & debts (short-term investment)

Balancing item Statistical adjustment to record errors & omissions in calculations

Official Reserves Account (ORA) Accommodates surpluses or deficits in overall balance

BOP equilibrium Trade & capital flows into & out of country equal over number of years

BOP disequilibrium Persistent tendency for outflows to be greater or less than

corresponding inflows

Expenditure-reducing policies Contractionary demand-side policies to reduce imports and hence AD &

NI of country

Expenditure-switching policies Policy that raises import prices relative to domestic-produced goods

Marshall-Lerner (ML) condition Sum of PEDX & PEDM > 1 for devaluation of currency to be successful in

correcting adverse BOP

J-curve effect Where current account worsens in short-run after currency devaluation

before improving

Foreign exchange (Forex) Trading of one country's currency for another foreign currency

Exchange rate Rate at which one currency is exchanged for another

Nominal exchange rate Exchange rate based on nominal value of currency before adjustment to

price changes

Bilateral exchange rate Exchange rate between two currencies

Trade-weighted / Effective

exchange rate

Value of currency against basket of other currencies of major trading

partners

Derived demand for currency Currency demand stems from foreigners' demand for our goods,

services & financial assets

Depreciation One currency weakens relative to another, when demand for it falls or

supply for it rises

Appreciation One currency strengthens relative to another, when demand for it rises

or supply for it falls

Purchasing power parity (PPP)

theory

Equilibrium rate of exchange between two currencies determined by

relative domestic purchasing power; exchange rates between two

currencies in equilibrium when equivalent domestic purchasing power

Fixed exchange rate Government of country fixes & guarantees official price of currency in

terms of other foreign currencies

Devaluation Government declares lowering of fixed exchange rate

Revaluation Government declares raising of fixed exchange rate

Freely-floating / Flexible

exchange rate

Exchange rate determined freely by market forces of demand & supply

in forex market

Managed float exchange rate Government lets market forces determine exchange rate but will

interfere to change it if beyond certain band

H2 Economics Definitions

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